Shell Goes Long on Brazil with Completion of BG Takeover

On February 15, Royal Dutch Shell completed the takeover of BG Group, marking a new era for the oil major. The deal allowed Shell to jump above Chevron to become the world’s second largest public oil and gas company by market value.

As the world shifts away from coal in the electric power sector, a transition that also includes many emerging market economies, Shell sees an enormous growth opportunity for natural gas.

BG group came with a hefty $53 billion price tag, and the purchase is a big gamble for Shell. It is also a massive bet on liquefied natural gas (LNG)—the combined company is now the world’s largest independent LNG producer, accounting for 16 percent of the global market. As the world shifts away from coal in the electric power sector, a transition that also includes many emerging market economies, Shell sees an enormous growth opportunity for natural gas.

But the acquisition of BG Group was also a large vote of confidence in one particular country, whose energy industry has come upon hard times of late: Brazil.

Cost cutting

In an effort to absorb the damage from low oil prices, Shell has had to rein in its ambitions. It has announced successive plans to cut operating costs and capital expenditures. It reduced capex by $8 billion in 2015 and will trim another $3 billion this year. All told, capital spending in 2016 will be 45 percent lower than it at its peak in 2013. Shell also has plans to divest $30 billion worth of assets over the next three years.

Shell has delayed or cancelled projects around the world to shrink its footprint during this period of low prices. The company scrapped its Arctic drilling plans in September 2015 after disappointing exploration results. A month later it indefinitely shelved an 80,000 barrel-per-day oil sands project in Canada, taking a $2 billion impairment charge. Already in 2016, Shell announced that it would lay off 10,000 workers – in part related to the BG merger—and it deferred a final investment decision on Bonga south west, an offshore oil project in Nigeria.

Shell shifts sights to Brazil

The divestment and cost cutting campaign does not extend to Brazil, where Shell appears to be doubling down. On February 16, Shell backed away from plans to sell off $150 million worth of offshore oil assets to Brazilian firm PetroRio.

Moreover, Shell had its sights set on Brazil when it purchased BG Group. BG has been operating in Brazil since 1994 and Shell will now take over the company’s sizable oil and gas assets in the Santos Basin, where some of vast “pre-salt” oil reserves are located. Pre-salt refers to offshore oil deposits located beneath a thick layer of rock and salt at extraordinary depths, often in excess of 18,000 feet. The landmark 2007 discovery in the Tupi field, estimated to hold 5 to 8 billion barrels of oil, kicked off an era of excitement, hype, and frenzied oil and gas exploration. BG Group was part of the consortium that discovered the Tupi field.

The importance of Brazil to Shell was obvious when the company’s CEO announced the completion of the BG acquisition from Rio de Janeiro on February 15. CEO Ben van Beurden gushed about Brazil’s potential, saying that it is a “top three” country for Shell, “the most valuable country in our portfolio” in terms of production, and “will remain a key destination country for us for investment dollars for at least a decade.”

No easy task

Shell faces an array of challenges in Brazil. The state-owned oil company Petrobras is legally required to own at least a 30 percent stake in Brazil’s pre-salt oil fields and also lead as the operator. Local content rules require exploration companies to procure equipment and contractors within Brazil, which inflates project costs.

Worse, Petrobras is in a state of crisis. The far-reaching corruption scandal has destroyed the company’s reputation and is costing it billions of dollars. S&P downgraded Petrobras’ credit to junk last year. Petrobras has more than $100 billion in debt, the most out of any oil company in the world. The debt load has suddenly become heavier over the past year with the plunging value of Brazil’s currency—84 percent of Petrobras’ debt is in a foreign currency. There is growing speculation that debt could be converted into equity, leaving shareholders with increasingly worthless stock.

Petrobras now expects production to fall to 2.7 million barrels per day (mbd) by 2020, down from the 2.8 mbd target announced last year.

Struggling with lots of red ink, Petrobras cut its spending and production targets in January, for the third time in six months. The company reduced planned spending for the period of 2015 to 2019 down to $98.4 billion, a 25 percent cut from June 2015. Petrobras now expects production to fall to 2.7 million barrels per day (mbd) by 2020, down from the 2.8 mbd target announced last year. What is striking, though, is the fact that as recently as 2014 Petrobras expected to produce 4.2 mbd by the end of the decade.

In short, Petrobras is in retrenchment mode and is not an enviable partner. To Shell, Petrobras is standing in the way of Brazil’s oil and gas potential. Shell’s CEO said on February 15 that the Brazilian government should ease rules that require the state-owned firm to control and operate offshore projects. That would allow companies like Shell to invest in oilfields that might otherwise lie dormant as Petrobras scrambles to fix its balance sheet. “It’s up to congress to decide. But I think it makes sense to call on other companies who have the technology, who have the money,” van Beurden said, according to Estado de Sao Paulo. “I don’t see how this is not beneficial for Brazil,” he added.

Of course, van Beurden is not a disinterested party. Liberalizing the offshore sector would have obvious benefits to Shell, which is betting big on Brazil.

For its part, though, the Brazilian government is actually considering loosening Petrobras’ grip on the pre-salt, realizing that Shell might be able to do better. Given the country’s deep recession, the government is also looking for new sources of growth. More foreign investment certainly looks appealing. Additionally, if the state-owned company sells off pre-salt assets, it could help it address its worsening debt problem. Petrobras has $24 billion in bond payments due this year and next.

Shell hitches its ship to Brazil

Despite Petrobras’ extensive problems, Shell is undeterred. The pre-salt oil fields are notoriously pricey, but not something that Shell sees as insurmountable.

In 2015, Petrobras estimated that the pre-salt breaks even at around US$50 per barrel. Shell’s van Beurden argued in Rio de Janeiro that costs have and continue to come down along with oil prices, as efficiencies and supply-chain savings trim expenses. The weakened value of Brazil’s currency will also reduce the local cost burden.

“I would expect the pre-salt in Brazil, the break-even price, to be very favorable, probably in the sort of [oil] price ranges that we think we are going to see in the course of this year,” he said to a group of reporters on February 15, declining to specify what he thinks oil will trade for in 2016.

With BG now under its control, Shell has 240,000 barrels of production in Brazil, or about 13 percent of the company’s total. As it ramps up investment, Shell plans on quadrupling that level of production to almost 1 mbd by 2020. That level of ambition stands in stark contrast to the painful cuts Shell is making to the rest of its portfolio.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.